What is the theory of liquidity preference and how does it help explain the downward slope of the aggregate demand curve?
That all else being equal, people prefer to hold on to cash (liquidity) and that they will demand a premium for investing in non-liquid assets such as bonds, stocks, and real estate. The theory suggests that the premium demanded for parting with cash increases as the period (term) for getting the cash back increases. Interest rates adjust to balance supply and demand, creating a downward slope of the aggregate demand curve.
Use the liquidity preference theory to explain how decreases in the money supply affect the AD curve.
An increase in the money supply shifts the money supply curve to the right. When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate demand to the right. When the Fed decreases the money supply, it raises the interest and reduces the quantity of goods and services demanded at any given price level, shifting aggregate demand to the left.
Give an example of a government policy that acts as an automatic stabilizer. Explain why the policy has this effect.
Automatic stabilizers are a part of the structure of the economy that work to limit the expansions and contractions of the business cycle. Taxes act as an automatic stabilizer. As an expansion: The progressive nature of income taxes automatically act to stabilize a business-cycle expansion, limiting the upswing of a business cycle that might tend to cause inflation. As a contraction: The progressive nature of income taxes also automatically stabilize the downswing of a business-cycle contraction. As the economy declines, and aggregate income falls, people pay a decreasing portion of income in taxes.
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